The Hindu Business Line : Flatter US yield curve ahead?

Voices predicting a US recession are growing louder by the day. Their view has been buttressed by the rash of weak data on several fronts - housing, jobs, consumer confidence (though it has picked up in the latest survey), business activity, leading indicators, et al.

Bond markets are doing their bit with the yield curve, which relates interest rates to time, becoming inverted, i.e., short rates are more than long for up to 10 years.

In effect, it is saying that the Fed will start to cut rates all the way down to the mid four per cent levels from the current 5.25 per cent.

Again, going by the market, this will happen sooner than later as the two-year yield itself is 40-50 basis points less than the current Fed Funds rate.

Every story has a villain. In this case there are two - housing and energy. The first was last year's darling but is this year's dog. It is almost as if the roof has fallen in.

The stock of unsold homes, prices and builders' sentiment have dropped sharply in recent months. The long-predicted and awaited housing slowdown has come. But will Armageddon follow?

It is a fact that this sector was the economic driver in the last few years, stoked by ultra-low interest rates on mortgages.

The boom in property prices also enabled "equity withdrawal" - a term used to describe borrowing against capital appreciation.

A post-9/11 slump was avoided thanks to the economy and consumer spending holding up on the strength of housing. Even the soaring price of crude and energy did not derail growth.

However, the last quarter has seen a perceptible slowdown. Third-quarter GDP rose only 2.6 per cent (annualised) - a noticeable fall from the 3.5 per cent levels of the previous quarters. Does it presage a recession?

Inflation continues to bother. Core CPI (ex-food and energy) is above the Fed's threshold of comfort of two per cent.

Mr Ben Bernanke, the Fed Chairman, thinks that decelerating growth will also moderate inflation and make further interest rate increases unnecessary.

Overall, the Fed is veering towards a neutral stance for now. Crude has fallen sharply to $60+ from its $78+ high some weeks back. It is a definite shot in the arm for the US and world economy.

Inventories of crude and finished products are comfortable. With Europe and Japan reviving and Asia buoyant, there is little reason to think the US will fall off the cliff.

Thus, while the chances of further Fed rises have receded significantly, inflation worries may delay action on the downside and that, in turn, means a flatter yield curve in the weeks and months ahead.

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